Debt reduction taskforce - bad timing

Tony Abbott recently announced his plan to establish a debt reduction taskforce to reduce government debt that he believes Labor foolishly incurred. I have no problem with governments paying down debt and aiming to have a zero debt balance over the business cycle, but does he really think that governments should pay down debt while the citizenry is trying to do the same? To me this sounds like a recipe for disaster.

Debt deflation is what happens when indebted households and businesses start to pay off debt after a period of debt accumulation. Money used to pay debts is not used for consumption and no longer circulates in the economy. This decreases demand, but also reduces the money supply. The net effect is to slow economic activity and reduce prices (deflation). To read quality analysis of debt deflation read Steve Keen’s superb articles here.

The government response to this should be to print money. Because a portion of the new money is used to pay debts, a far smaller portion circulates in the economy to cause inflation. If it is done well, it should slow deflation, keeping demand and prices stable, and allow debts to slowly be repaid without the value of debt rising in proportion to incomes.  Whether this will promote further malinvestment (investing in non-productivity improving assets) remains to be seen.

Establishing a taskforce is a clear sign that it is not Abbott’s intention to pay down government debts by printing money. His plan appears to be the reduce government spending to pay debts – the exact same thing households are currently doing.

This will only exacerbate the decline in demand and accelerate our march towards deflation.